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What is a Funding Rate?

Author: Nicolas Tang

Traditional futures contracts always have an exact expiration or settlement date. Although its price deviates from the underlying asset’s price (basis) during its lifetime, these will always converge at expiration.

Perpetual contracts, on the other hand, never expire and never settle in the traditional sense. As such, their prices could end up becoming significantly different than the underlying assets that they derive their value from. To prevent this from happening, a Funding Rate mechanism attempts to tether a contract’s price to its asset’s price.

(To learn more about perpetual contract, read What is a perpetual contract?)

The funding rate is calculated by considering the interest rates for both trading pair currencies and the Premium Index. The calculation either yields a positive (longs pay shorts) or a negative (shorts pay longs) funding rate. On Phemex, there is an exchange of payments that happens every 8 hours with the funding rate deciding who pays who. This exchange of payments causes the Last Traded Price to move closer to the Mark Price.

For example, let’s imagine that the current Last Traded price for a product on our platform is significantly higher than the Mark Price. Logically, this means that there are more traders with long positions. As such, they will likely end up paying short position holders at the time of funding. Because traders are aware of when funding will occur, they then become less likely to want to hold these positions and more likely to sell. Hence, the Last Traded price will continually drop and approximate the Mark Price.

 


 

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